Understanding the Stock Market: What It Is and How It Operates

TradingKey - If you are trying to figure out what investing means and what the stock market is or how to invest in the stock market, you are not alone. Many new investors have the same question—and for many people new to investing, the stock market may seem very complicated.

However, the stock market does not have to be complicated. It is just a place where you buy and sell equity interests (or ownership interests) in publicly traded companies. A very important part of our economy, the stock market allows everyone to accumulate wealth over time.

In this guide for beginners, I will explain what the stock market is and how it works, discuss why companies choose to be public and how others can safely invest in the stock market.

The term "stock market" refers to a vast collection of place-based locations throughout the world, connected into a global marketplace network where people trade/gain ownership (equity) of shares of public businesses through broker platforms. 

Most people think of stock exchanges like the NYSE and NASDAQ when they think of the "stock market." While NYSE and NASDAQ are two of the largest and most prominent stock exchanges, these exchanges are only a small sample of a much bigger marketplace, even to the point of including Over-the-Counter (OTC) as part of the stock market. 

In America, the SEC regulates any company that wants to offer publicly traded stock and ensures that the company registers and provides regular financial reporting to its investors, creating sufficient transparency for investors and ensuring fair market pricing through a regulated marketplace.

The stock market is a function of connecting companies with investors; it facilitates the transfer of money from one to the other via a broad, primarily digital network composed of various exchanges, brokerage houses and Over-The-Counter (OTC) Dealers, which are governed by a framework of laws that prohibit the commission of fraud or the undertaking of any activities that would constitute an abuse of position. 

Investors participate in the marketplace for many reasons: some are seeking a source of income from their investments through dividends; others desire shares as instruments for capital appreciation with a view to selling them supplemented by interest income; while others invest primarily to acquire the right to vote on matters affecting the management of the companies they invest in via their common stock ownership. 

In all cases, by owning shares, purchasers have an ownership interest in the company's retained earnings and the right to participate in decisions affecting the operation of the corporation.

A business cannot sell its stock on the public market due to a lack of SEC registration. To list on a public exchange such as the NYSE or Nasdaq, a company must first register and comply with SEC requirements.

An IPO is usually the most common method for becoming publicly traded. However, in recent years there has been another option available: SPACs.

The primary market, or the Initial Public Offering, involves trading between the public and early investors/insiders/underwriters. In addition to IPOs, private placements occur when the issuer sells securities directly to buyers without the complete public registration process.

A share in a corporation represents an ownership (or interest) in the corporation. The number of shares issued (or outstanding) determines how large an interest you have (the percentage). Private companies typically issue fewer shares than public companies; thus, the value or interest of each share is usually greater. 

For example, Apple has billions of outstanding shares, so the price of one share represents a small percentage of the total value of the company. 

Stock prices fluctuate based on the relationship between supply and demand in the marketplace. For example, if a company has more potential buyers than sellers on the day that the stock market opens, then the price of the stock will typically increase. Conversely, if there are more potential sellers than buyers, then the price of the stock will typically decline. 

Prices can also change according to individual perception, so what one investor may view as an expensive price may be viewed as a great value by another investor. Therefore, the difference in perception keeps the stock market active and makes it difficult to predict future stock prices.

When a company goes public, its shares can now be freely traded on the secondary market (commonly known as stock exchanges). Traditionally, stock exchanges have been physical marketplaces where buyers and sellers interacted directly with each other, but today they have become more of an online marketplace—known as a "virtual exchange"—and continue to serve as an important source for capital for both private and public companies.

In addition to providing a way for companies to raise capital and investors with access to transparent prices and real-time trading, these exchanges are established, regulated markets in which investors can easily buy and sell their shares in exchange for cash.

The New York Stock Exchange (NYSE) and the Nasdaq Stock Market are two of the largest and most popular exchanges in the United States (U.S.), while the London Stock Exchange, Tokyo Stock Exchange, and Shanghai Stock Exchange are major stock exchanges around the globe. Each exchange has its own set of rules and regulations (i.e., rule book), in addition to national laws, to ensure a fair and transparent marketplace and help maintain investors'/shareholders' trust in the marketplace.

A major benefit of using an exchange is that there are many opportunities available at an exchange, which gives you greater liquidity, or the ability to quickly find a buyer or seller at a given price. In addition to providing a trading venue for public companies, trading on most exchanges enables them to list their shares on other markets and gives investors more choices and more access to various investment opportunities.

Investors can buy and sell securities through an electronic network using over-the-counter (OTC) markets without having to go through an exchange. 

In OTC markets, investors use brokers and dealers who quote prices and negotiate prices via phone or electronically. Over-the-counter markets are often the venue where smaller and less liquid companies trade if they don't meet the listing requirements of the major exchanges and therefore have more difficulty locating comprehensive and reliable information about them. 

Investors should consider the increased risk of the lack of transparency associated with OTC trading due to the lower standards and lesser amount of regulatory attention versus exchange trading.

In addition to the common stock available in the public market, there is also a wide range of securities available on either an over-the-counter (OTC) market or an exchange, and they are included in the stock market. 

• American Depositary Receipts (ADRs) are used by U.S. investors to gain indirect ownership in foreign companies. ADRs allow U.S. investors to buy shares of foreign companies without having to deal with complicated foreign currency exchanges or navigating foreign markets directly. 
• Derivatives (e.g., futures and options) provide investors with exposure to changes in the price of an underlying asset (such as stocks, bonds, commodities, or currencies). 
• Mutual funds are a type of investment vehicle where a large number of individual investors pool their money to buy various types of securities in one account. 
• Exchange-traded funds (ETFs) are similar to mutual fund shares, but they can be purchased and sold on the stock exchange like individual shares. 
• Preferred stocks usually have a fixed dividend and take priority over common stock for distribution or in bankruptcy. 
• Real Estate Investment Trusts (REITs) are companies that buy, own, manage, or finance properties that generate income, and as a condition of being classified as a REIT in the U.S., they must distribute 90 percent of their taxable revenue to shareholders as dividends.

The stock market plays several key functions in the development of modern finance, and together these functions support the overall functioning of the stock market as one of the mainstays of modern finance. 

One of the key roles of the stock market is that public companies are required to report information about their company on a regular basis according to certain restrictions. This increased level of reporting requirements makes it much easier for an average investor to see how a public company is doing financially. Many people use the stock market performance as a general indicator of the overall health of the economy, with rising stock prices generally being associated with increasing profits and growth, while falling stock prices generally reflect problems or difficulties in the company being reported on. 

For an individual investor, the stock market offers an opportunity to accumulate wealth over a period of time, with the expectation that over time stock returns are likely to equal or exceed the rate of inflation, which is why stocks are so important to retirement planning and long-term financial security.

 In addition, another important aspect of the stock market is liquidity, which allows investors to easily buy or sell shares when necessary without much difficulty. For a company, a way of obtaining funds for future growth or development is to list shares on the stock market (i.e., sell shares to the marketplace) to obtain financial resources to help finance business growth and development without needing to incur debts. 

Finally, by providing continuously updated prices to investors, the stock market serves as a mechanism for directing money to strong companies and away from weak companies, thereby allocating money to the places where it is most productive for business growth and development.

Throughout the history of exchanges, stock markets have provided the funding for worldwide trade and commerce. They enabled the ability to fund long-distance trade voyages that linked colonial trading ventures from all parts of South Asia, the Americas, and Africa. The original purpose of the stock markets was relatively unimportant.

However, in contemporary times, stock markets have been seen as both an indicator and a catalyst for the economic and financial growth of a country. Today, due to decades of investment in financial markets and institutions and the development of investment markets and financial institutions at the center of most economies around the world, the stock market has evolved into something much more than just a location to buy or sell stocks from large corporations; it has become an essential structural component of all modern economic systems. 

As a result of the many layers of transactions and financial instruments that are connected via the stock market, its influence and impact are felt throughout the entire global economy where we conduct business.

The range of investors participating in the market includes both institutional-sized organisations as well as those investing as individuals. 

Many institutions will invest significant amounts of capital through the use of pension funds, mutual funds, insurance companies, and hedge funds. The amount of capital they invest and the volume they trade create an opportunity for them to influence trading, thus creating more opportunities for themselves. 

On the other hand, retail investors tend to use online broker platforms to buy and sell securities for their own accounts. Retail investors can include those who have never traded before as well as experienced traders. Lastly, high-net-worth accredited investors have experience in the securities market and can invest in private equity and venture capital opportunities according to SEC rules. 

Most long-term investors are typically looking to accumulate wealth over time by holding positions in stocks, ETFs, and mutual funds that they believe have an underlying business's strength, earnings power, competitive advantage, and growth potential, often with research or through a financial advisor's guidance. 

Conversely, traders typically seek to take advantage of market movements over shorter periods of time by employing various strategies when trading stocks, options, futures contracts, and other financial instruments and may only hold their position for a few minutes or days. 

Traders may often rely on technical analysis and analysis of market charts and statistical data in an effort to predict future price movements. While quick gains are possible, the risks associated with trading and speculating are much higher than those associated with long-term investing, and they also require active involvement.

The securities markets and the investor's broker act as intermediaries to facilitate the purchase and sale of stocks and other types of securities. 

For individuals who want a deeper, more customized approach to their stock and bond(s) market investment strategies, full-service brokers supply a wide range of services, while discount brokers and online trading platforms focus on delivering low-cost online trading execution for individuals wishing to make their own investment decisions. 

Many people are now using the internet as the primary method by which they trade stocks on the securities markets, as digitally based online trading platforms typically provide easy-to-use tools, research materials, education, and access to real-time market data (news), plus robo-advisors have been developed that can automate many aspects of the planning and investing experience for a relatively inexpensive fee.

 In the USA, the SEC (Securities & Exchange Commission) and the Financial Industry Regulatory Authority (FINRA) oversee the operation and activities of all brokerage houses and registered representatives. FINRA creates, develops, and enforces policies and procedures applicable to all broker/dealer operations.

Oversight affects the types of products available for trading and their methods of trading. 

The SEC was established in 1934 after the great stock market crash of 1929 and during the Great Depression. The SEC has a mandate to “protect investors” and “maintain fair and efficient capital markets while encouraging investment.” 

This is done by enforcing the prohibition on market manipulation, insider trading, and fraud, and by requiring publicly-traded companies to provide adequate information to investors so they are able to make well-informed investment choices when purchasing stocks. The SEC additionally has jurisdiction over the operations of exchanges, the activities of brokers or dealers, and the actions of investment advisors, mutual funds, and public utility holding companies. 

Exchanges impose their own listing qualifications, which require companies to provide timely financial information, such as quarterly reports, as well as prompt reporting of any significant changes concerning a company. In addition, FINRA provides investor protection through the regulations imposed on the operation of broker-dealer firms. 

This type of regulation is performed by various counterparts worldwide in their respective countries or regions. All countries desire to provide fair trading practices and protect investors, as well as to provide a level of confidence among investors in the global stock market where financial unrest in one area may quickly impact another.

While many people see stock prices as just a number on their computer screens, the truth is that stock prices are determined through negotiations between buyers and sellers, and every trade represents an agreement on price at the time of the transaction. 

What determines the price of a stock can be deemed to fall into two categories: fundamental and technical. Fundamental factors relate directly to the company, including revenue, profit, earnings and how the company is perceived in the marketplace, while technical factors have to do with what others perceive about the company based on historical trends in terms of market sentiment, trading patterns and price history. 

A stock may have high price points due to a company performing well or having future prospects that people feel are good, but high price points can also be attributed to other factors such as stock splits, dividend payments or share buys. 

When an individual stock drops in price doesn't necessarily mean money has been taken out of the whole market, but rather indicates that the individual stock's current market value is lower than it was previously. 

When there is a positive surprise, such as a company reporting greater-than-expected profits, it frequently leads to investors wanting to acquire shares and drives prices up; however, when interest rates fluctuate, economic indicators change or there is uncertainty in relation to international conflict, the sentiment of investors will change and can cause the prices to fluctuate in multiple sectors.

People learn about the stock market through its movement on a daily basis. The Dow Jones Industrial Average is made of 30 companies in the United States and represents the largest American companies. The S&P 500 represents the 500 largest publicly traded companies. 

Indexes are used to show all of the stocks in the entire market but also allow you to look at a specific field, such as technology or healthcare, and it is a guide to compare your portfolio against the indexes you select as benchmarks. If you have an investment portfolio containing several stocks in technology, you will be able to evaluate your performance compared to that sector using a technology index.